The Sure Thing

BankUnited's resurrection illustrates everything that went wrong in the housing bubble.

On Jan. 24 BankUnited, a smallish thrift based in Coral Gables, Fla., filed a prospectus for an initial public offering. It was an astounding resurrection. Not quite two years earlier BankUnited had filed for bankruptcy, brought down by bad residential real estate loans concentrated in its home state of Florida. Subsequently BankUnited had been taken over by a consortium of investors—including big-name private equity firms Blackstone, Carlyle, W.L. Ross, and Centerbridge—that put in $945 million to recapitalize the bank. Now BankUnited and its investors are having their moment of triumph. The IPO is supposed to raise some $630 million, almost $500 million of which will go directly into the pockets of the private-equity firms—a stunning windfall, especially in these days of more meager returns for private equity.

If you took BankUnited's rebirth to be a parable about the private market's ingenuity and its capacity for renewal you would be missing the point. What it really illustrates is private equity's ability to make a fortune off a government guarantee. Most of the risk in the deal is borne not by the private equity firms, but by the Federal Deposit Insurance Corporation's deposit insurance fund. The FDIC expects to take a $5.7 billion loss on BankUnited, making this the second most costly bank failure ever, right behind the notorious IndyMac. Nor are BankUnited's customers getting any government handouts. Even as the FDIC shields investors from too much downside risk, one way the private equity firms can collect from the FDIC is by kicking people out of their homes. If you were searching for an example of what went wrong in the bubble years, you couldn't do much better than BankUnited.

BankUnited was founded in 1984 as a state-chartered savings association by Alfred "Fred" Camner, a Wharton graduate who also got a law degree from the University of Miami. The bank got a federal thrift charter in 1993 and became the largest financial institution headquartered in Florida. BankUnited was known as a conservative lender that focused on residential real estate. As other companies were being sold to industry giants in the consolidation wave that followed the savings and loan crisis of the late 1980s, BankUnited became known as a survivor.

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The bank lost its reputation for sobriety during the more recent bank crisis. As lending fever took hold in the aughts, BankUnited executives dove into the riskiest of risky loans: so-called option adjustable rate mortgages. An option ARM allows the borrower to choose how much to pay every month. One of the borrower's options is a minimum monthly payment that allows the borrower to pay an amount that's even less than just the interest owed. That results in a phenomenon called "negative amortization," wherein the principal, instead of shrinking, actually grows because the unpaid interest gets added to the original principal amount. Once the balance of the loan reaches a certain level—usually 110 percent to 115 percent of the original principal—the minimum monthly payment option is withdrawn and the borrower is now required to pay in full a monthly mortgage that is suddenly a lot more money. Given that the borrower probably selected the minimum payment because that was all she could afford, you can see how this arrangement would usually end badly. According to a letter written by the law firm that represents the FDIC, BankUnited's mortgage portfolio more than doubled from $6.1 billion at the end of 2004 to $12.5 billion at the end of 2007, by which point option ARMs represented a stunning 70 percent of the total mortgage loans outstanding. By 2008, option ARMs represented 575 percent—yes, that's the right number—of the bank's total capital. (A bank's capital isn't the same thing as its assets; it's the money on hand to serve as a cushion in the event of losses.) By spring of that year, fully 92 percent of the option ARM portfolio was in a state of "negative amortization," meaning borrowers probably couldn't pay, according to an audit report later done by the Treasury's Office of the Inspector General. By the following year, the stock had gone into free fall, and the regulators stepped in.

The FDIC's lawyers alleged that the bank's former executives had committed "wrongful acts committed in connection with the origination and administration of unsafe and unsound real estate loans." BankUnited, the FDIC lawyers also said, had made "the special Option ARM lending product—appropriate for only a small portion of the population—available to every potential bank customer." (Camner, in a statement to the South Florida Business Journal, called these assertions "nothing more than unfounded speculation.") According to one confidential witness in a class action lawsuit, there were "numerous customer complaints about not understanding the effect of negative amortization." Another witness said that managers told loan officers to "sell Option ARMs to every customer, including those that could not afford them."

After the FDIC took BankUnited into receivership three separate groups submitted bids. The FDIC chose the investor consortium of Blackstone, Carlyle, and various others. The new owners installed as CEO John Kanas, a highly regarded bank executive who'd made a fortune after he built, and then in 2006 sold to Capital One Financial, North Fork Bank. Kanas reportedly invested $23.5 million of his own money in the BankUnited deal.

Why such competition to acquire a failed bank? Because the FDIC agreed to a "loss sharing agreement." "Sharing" is here a euphemism for "covering" because the FDIC will absorb 80 percent of any losses on BankUnited's entire existing loan portfolio, along with some other BankUnited securities. Should total losses exceed $4 billion, the FDIC will absorb 95 percent of the remainder! BankUnited's IPO prospectus says that even in a worst-case scenario, if all the assets covered by the loss sharing agreement lost 100 percent of their value, the bank "would recover no less than 89.7% of the [unpaid balance on the loans] as of the acquisition date." This, of course, explains why the FDIC expects to lose that $5.7 billion. (Technically this won't be paid by ordinary taxpayers because the FDIC's deposit insurance fund is funded by fees collected from banks. But the banks typically pass along such costs to consumers. And there have been worries that the fund, whose balance has declined precipitously, could go bust, at which point ordinary taxpayers would be on the hook.)

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It's no knock on the highly skilled John Kanas and his new management team, who may yet provide a great deal of value, to observe that the resurrected BankUnited's chief market advantage right now isn't management brilliance but corporate welfare. "[A] majority of BankUnited's revenue is currently derived from assets that are covered by the loss sharing agreements," the IPO prospectus boasts. As a result, BankUnited is "one of the most profitable and well capitalized bank holding companies in the US," with an enviable 17.7 percent return on equity.

You could argue that, amid the current fragile recovery, banks need a lot of money right now so they can revive the economy by making new loans or restructuring old ones. But out of the $630 million that the BankUnited IPO is expected to raise, BankUnited itself will receive a mere $86.2 million. The rest of the money from the IPO will go to the sellers, who include Kanas and some other smaller investors. (Kanas will still have 5.5 million shares projected to be worth more than $100 million, and the private-equity firms will own stock projected to be worth some $1.4 billion, so they aren't bailing out.) The FDIC, which in a way is making the IPO possible in the first place, brings up the rear: It's expected to get a payment of $25 million.

The FDIC says this is a good deal. Jim Wigand, who oversaw many failed bank dispositions and is now director of the FDIC's Office of Complex Financial Institutions, points out that by statutory mandate the FDIC must limit losses to the deposit insurance fund. At the time the deal was struck, he says, this was the best option to achieve that goal. Indeed, the FDIC says it would have cost the fund an additional $1.5 billion to liquidate BankUnited rather than sell it. And BankUnited is required to participate in a loan modification program that the FDIC deems acceptable. When a homeowner can't meet mortgage payments, the bank is required to look into a modification and choose the "most effective loss mitigation strategy," according to its prospectus and the FDIC agreement. That means the bank must calculate which option would bleed the FDIC fund the least: a foreclosure, a short sale, or a restructuring. If foreclosure is the choice, the homeowner gets nothing—but the private equity firm still gets 80 percent of its losses reimbursed by the FDIC.

The FDIC's Wigand says that quite often foreclosure isn't the least costly option; loan modification is. In those instances, presumably mortgage holders stay in their homes. One person familiar with BankUnited says that in the long run loan modifications are more profitable to the bank than foreclosures. But here's what the IPO prospectus says: "Homeowner protection laws may also delay the initiation or completion of foreclosure proceedings on specified types of residential mortgage loans. Any such limitations are likely to cause delayed or reduced collections from mortgagors. Any restriction on our ability to foreclose on a loan, any requirement that we forgo a portion of the amount otherwise due on a loan or any requirement that we modify any original loan terms could negatively impact our business, financial condition, liquidity and results of operations."

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In other words, when the government bailed BankUnited out, it didn't necessarily do homeowners delinquent on their mortgages any favors.

Update, Jan. 27: The FDIC feels three points that add context should have been included in this article. They don't correct anything that appears above, and I'm happy to enumerate them here.

1.) The Office of Thrift Supervision was the primary regulator of BankUnited, not the FDIC. But because the FDIC acts as deposit insurer for all banks and oversees the deposit insurance fund, the FDIC had no choice but to step in as the bank's receiver. BankUnited had approximately $9.34 billion in insured deposits. These are liabilities that the FDIC is legally obligated to pay no matter what. The winning bid from the private equity consortium cost the fund less than any alternative would have; the only alternate bid by a banking institution would have cost the FDIC an additional $1 billion.

2.) Because BankUnited gets its money immediately upon a loan modification, that gives the bank more incentive to modify loans, not less, than other lenders without such an arrangement might have.

3.) The FDIC deposit insurance fund is now in reasonably good shape, and any fears about its solvency should be put to rest. Throughout the crisis, the FDIC maintained funding through assessments on the banking industry.